Understanding Borrowing Capacity vs Serviceability

Have you ever applied for a loan only to have it rejected? The reason often lies in the bank assessing your borrowing capacity versus your serviceability. 

What's the Difference?

Borrowing capacity refers to the maximum amount you can borrow at a given time, based primarily on your available capital, such as savings and equity.

Serviceability, however, is about how much loan repayment you can realistically handle based on your income and expenses.

These two numbers can sometimes align closely but often diverge significantly. You may be able to service a much larger loan than your current assets allow you to borrow.

How Banks Evaluate Your Borrowing Power

Lenders calculate your serviceability by examining your income stream, regular expenses, and potential rental income from the property. As a general guideline, you may be able to borrow around six times your annual income.

However, not all income sources are viewed equally. Self-employment, casual, or contract work is often seen as less secure than a full-time salaried job. Some lenders may use add-backs from business financials, while others only consider the latest year's figures.

Your stated expenses are also heavily scrutinised. Even if you live rent-free, banks use minimum household expenditure benchmarks. Reducing discretionary spending like dining out can help.

Existing debts like credit cards, personal loans, and car payments directly impair your borrowing capacity. It's wise to pay these off or reduce limits before applying.

Other Risk Factors Lenders Consider

Beyond just your finances, lenders evaluate various risk factors about the property itself:

- Location risks like busy roads or nearby nuisances

- Land quality, terrain, and drainage issues

- Environmental risks like flood zones or fire hazards  

- Expectations of declining property value in the area

- Smaller units below a size threshold

If the perceived risk is too high based on these factors, your loan may be denied despite adequate borrowing capacity.

Calculating Your Borrowing Limits

Two key calculations help determine your maximum borrowing amount:

1.  Debt Service Ratio - Your proposed loan payments divided by gross income, typically capped at 30% for singles and 40% for couples.

2.  Net Debt to Income Ratio - Total debt payments compared to net disposable income, which should be at least 25% higher.

Boosting Your Borrowing Power

To increase your borrowing capacity, you can either raise your income through promotions, second jobs, or higher-yield investments; or reduce your expenses by trimming your lifestyle and eliminating liabilities.

Lenders prefer principal and interest repayment schedules over interest-only, as they assess serviceability over a 30-year period. A mortgage broker can help structure your borrowing optimally across different lenders.

 While pre-approvals can give you an idea of your purchasing budget, the property still needs to meet the bank's investment criteria for final approval. Too many pre-approval inquiries in a short span can actually hurt your credit profile.

The Bottom Line

Balancing borrowing capacity and serviceability is crucial when making major financial decisions like purchasing property. With these lending insights in mind, you can ensure you're making well-informed choices aligned with your goals.

If you'd like to learn more about investing in residential real estate, check out my guide, "Residential Property Investing Explained Simply." It covers a wide range of topics to help you get started. I'm also happy to discuss how I've helped other investors build their portfolios - just reach out!